Market Recap: Weathering the Storm

This week markets recovered from previous risk reduction and de-leveraging that has occurred from the fallout of the credit bubble unwind. Implied volatility was crushed, the curve flattened 20bps, yen fell, crude fell below $70 and stocks rallied to over 50% retrace. We expect the markets to remain subdued during the pre-labor day week but expect volatility to pick up when the big boys come back from the beach as we should get some feel for direction into year end.

International Interests: Carry on

Yen carry trade pairs rebounded this week as the risk aversion trade backed off and the BOJ refrained from tightening on recent market turmoil. EURJPY, our preferred risk appetite gauge has retraced 50% of it’s sell off bounding 7% off the previous week’s low and seems to be following the lead of stocks which have also retraced 50%. We are looking for more of the same next week for the carry trade as traders are subject to risk appetite of the equity and credit markets. It is unlikely any big positions will be put on in front of Labor day thus barring any blow ups in credit land, would look for a quiet week. Economic reports pick up steam the following week with the September 18 Fed meeting looming large on the horizon. The dollar has given back some of the de-leveraging rally cracking the 81 support level on Friday. With the Fed staying on hold but active in money markets we think the dollar should remain relatively strong. The de-leveraging at discounts to par is clearly a positive for dollars so expect the DXY to reflect this activity, trading lower as stocks and spreads rally and higher on sell offs. GBP popped back over the $2 level and is still a great place to hide earning a strong yield with arguably the tightest central bank.

Cost of Capital: Curve Whiplash

Bond prices held their bid despite some unwinding of risk aversion trade. The curve saw most of the action flattening 20bps as the front end underperformed as the flight to quality trade was reduced on the Fed’s ability to loosen up the money markets. We identified the yield curve as the focus of bond markets with it reflecting fear in the front end and risk premium in the long end. With the Fed presumably holding the line on the Fed funds rate expect the curve to continue to flatten. If we were to see any disruptions in credit expect the curve to steepen. Since we think next week will be quiet we also expect the curve to trade with a flatter bias. Our 5YR backed to 4.40% this week, shy of our 4.50% target. We will look for further retracing next week and are still buyers at that level, though we think nth could make it to 4.75% on a 50% move off the highs. That being said, look to add on pullbacks but with next week likely to be quiet, investors may be best served by sitting on the side and look for 4.75%, our original retrace target.

Beta Maximus: Risk Rewind

Equity markets continued their recovery in a grinding trade higher that seemed to vibrate around Dominick’s 1467 target. We were anticipating a bounce this week and the lack of negative news coupled with a vote of confidence from the Fed and BAC’s $2b investment in CFC removed some fear and drove some buying and short covering into the weekend. The near term pattern is still unclear but we think it will begin to take shape next week as traders set up for post labor day into year end. We are expecting to see some pullback as this bounce has rallied 7% in as many days and we need to consolidate those gains. We are looking for the market to continue the advance after a sell off to get the bear juices flowing again just in time for another short squeeze. We are confident that a rally will take us at least back to 1500 but we are not sure what to do with it. At this point, we prefer to add a little long exposure, maybe 50%-60% of ones bogey, on the next pullback to 1425-1400 and decide whether or not to add or lighten up when we get back towards the highs based on the data, price action and sentiment. Currently the credit problems have many looking to sell this rally in anticipation of a major sell off. We as contrarians are skeptical these pundits will be right before they are squeezed out of their shorts.

Duke & Duke: Casino Boogie

Crude oil continues to trade on momentum and broke the $70/brl level this week on some capitulation type selling. When it became apparent hurricane Erin was going to miss the Gulf coast speculators puked and the selling got a little ugly which put in a near term low as price bounced out of a falling wedge. We are looking for the bounce to grab some legs for a run back near the mid-70s before resuming the decline. As always, crude can be very sensitive to reduced risk premium, geo-political tensions and volatile dollar fx pairs. We so no reason to believe that fundamentals are driving price action and thus prefer to let the gamblers trade the momentum. There will likely be a constant tug of war with the opposing forces of slowing growth and higher premiums driving the trade.

Ex Ante Factor: The Intimidator

This week we wanted to turn our attention to the bond market and more specifically the action in the long end of the curve. After putting in a panic low during the BSC hedge fund debacle the long bond is breaking out of the downtrend channel and the 10YR contract appears to be finishing off an impulsive 5 wave advance. Of course, the obvious question becomes, “5 of what”? Regardless of that answer, we should see some consolidation either way but the nature of how we emerge from a pullback is what we are focusing on as it carries big implications for the entire capital market and economy. We have been following this fork on the bond contract and how it handles the upper trend line on a pullback give us insight to the degree and direction of the whole coupon curve.

Dominick has always told me he believes bonds and currencies tend to move in 3s, implying they are more apt to trade in ranges as opposed to longer term trends. “The dollar can’t go to zero,” he says. We have a few theories as to why this is true and while the dollar could be technically worthless, his is the simplest and likeliest answer. Currencies are relative values and interest rates reflect growth rates and inflation premiums which are cyclical. Nominal yields can’t go negative, the bond contract isn’t going to 1000 and the dollar isn’t going to 0. Sure, we could be analyzing the Zimbabwe $ and any other hyper-inflationary situations and call the move a multi-year impulsive or 5 wave trend but even these fat tail situations will eventually correct within a band and be labeled 5 of A or C.

With this said and viewing the current 10YR note pattern as a series of 3s and will thus be interpreting this move as an A or 1 of A with consolidation to be a 2 or B wave. This would make sense as the market digests the recent gains from a V bottom reversal while we await an onslaught of economic data and a Fed meeting on the 9/18. This will be some of the first empirical evidence reported since the credit markets seized up.

Some of the highlights include:
8/27: Existing Home Sales
8/28: FOMC minutes
8/31: Personal Income and Spending, Chicago PMI, Bernanke speech from Jackson Hole
9/4: ISM index
9/5: Fed Beige book, Pending Home Sales
9/6: ISM services
(Red Alert: the first indication to the degree of damage from the credit situation on what has been the most robust sector of the US economy)
9/7: Non-farm payrolls

According to my math, 12 month trailing nominal GDP is growing on average at roughly 4.90% with the last two quarters tracking at an average around 4.25%. We are about to get a glimpse to the magnitude the credit crunch had in an already decelerating economic environment. The reaction from the bond market, and maybe more importantly the yield curve, will provide the window for future economic activity.

The 10YR note yield tracks pretty close to long term GDP growth and is currently yielding 4.62%, an appropriate discount in my opinion. Greenspan’s “conundrum” and Bernanke’s “savings glut” were nonsense. The flattening yield curve and subsequent inversion perfectly predicted that growth rates would fall below cost of funds. If Bernanke is looking at the right indicators he should be massively easing. He must be ignoring the indicators or trying to prove a point. We are looking at Elliott, who is pointing to a potential multi-month ABC rally and at minimum targeting the previous high around 114 and the 2002 highs around 120 on the TY1 can’t be ruled out. The extreme case could put us close to 3% on 10YR yields implying recessionary conditions as “real” growth would be essentially flat.

I fear Bernanke is being haunted by his helicopter speech causing him to be tighter than necessary. Granted he can’t affect the re-pricing of risk premium which is at the core of the current market volatility, but had he been able to better calibrate short term funding costs to ease the obviously deceleration in values of collateral we might not have seen such a rapid de-leveraging of credit. It’s almost like he challenged the bond market by not easing at the last meeting and market decided they would take matters into their own hands. Shutting down the repo and commercial paper markets proved that they could bankrupt major institutions in a matter of days. That is some awesome power.

Clinton advisor, James Carville once said:
“I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter, but now I want to come back as the bond market. You can intimidate everybody.”

Hell yes you can.

What is the discount?
Risk continued to perform well this week with the yield falling on the S&P and medium grade corporate debt 14bps and 8bps respectively. Risk premiums fell across the board but still remain cheap relative to the 2007 average. We think this could continue to support stock prices for the near term but view the 300bps of implied equity premium to be still narrow and would feel better about longer term positions at a spread of 500bps.

Bottom Line: This week all markets traded according to expectations. The dollar retreated as the curve flattened and risk was reapplied. There is not much to say other than we expect this week to be slow and would advise investors to sit tight in their 5YR notes while the amateurs chop themselves up. Post Labor Day should be much more informative and provide guidance for direction